Why we’d avoid Keppel DC REIT after its 2Q22 results

TL;DR

• Keppel DC REIT’s 1H22 distributions per unit (DPU) of 5.049 cents met market expectations, with no surprises from higher electricity prices this time. 
• Its portfolio occupancy fell slightly to 98.2% as one of its customers in Malaysia took up less space when renewing its lease.
• While Keppel DC REIT has a healthy gearing of 35.3% currently, its debt levels will rise upon completion of its recently announced acquisition in China.
• Keppel DC REIT offers a dividend yield of 5.0%, just slightly above the average yield on the 10-year Singapore Savings Bond. 
• We’d still be staying away until there is more evidence that it is able to make more acquisitions and achieve higher DPU growth. 

What happened?

You’d know many investors in Singapore have an interest in Keppel DC REIT from a poll we conducted this week on our Telegram group.

It’s a big week for US earnings, with Apple, Amazon, Alphabet, and Meta all reporting the results.

But the stock that the Beansprout community was most interested in was Keppel DC REIT!

So here’s a quick rundown - Keppel DC REIT reported 1H22 distributions per unit (DPU) of 5.049 cents, an increase of 2.5% compared to the previous year. 

Investors can be relieved that the distributions met market expectations, as the acquisitions it made previously have been contributing as expected. 

There were also no nasty surprises coming through from the impact of higher electricity prices this time. 

What we learnt from 2Q22 results

#1 - Higher electricity prices had negligible further impact

One of the key concerns that investors had about Keppel DC REIT after its 1Q22 results, was how higher electricity costs would affect its distributions.  

After all, it had earlier shared that a further 10% increase in our portfolio electricity costs would impact is FY 2021 DPU by about 3% on a pro forma basis.

Keppel DC REIT subsequently came out to clarify that based on existing contracts in place, a further 10% increase in electricity tariffs from 1Q2022 would lead to 1Q2022 DPU being about 0.009 cents per unit lower on a pro forma basis. 

That works out to just a 0.36% impact, which is not as bad as initially feared. 

This turned out to be the case in 2Q22, where higher electricity prices had an insignificant impact on its distributions. 

The good news here is that with the decline in oil prices, electricity prices in Singapore have fallen in recent months as well. 

Here, we can look at wholesale electricity prices, which is the price that companies can buy electricity directly from the grid. This is different from the price that you’d pay an electricity retailer for a fixed contract and reflects the underlying demand and supply picture. 

The wholesale electricity price, as measured by the Uniform Singapore Electricity Price (USEP), fell to about S$297/kwh in 2Q22 from S$353/kwh in 1Q22. 

This might have taken some cost pressure off Keppel DC REIT.

#2 - Portfolio occupancy fell slightly

The occupancy of Keppel DC REIT’s portfolio fell slightly to 98.2% as of June 22 from 98.7% in March 2022. 

This was because one of its customers at Basis Bay, Malaysia, decided to take up a smaller space when renewing its contract. 

As a result, the occupancy of this property fell to 40.2%. 

The Basis Bay data centre accounts for less than 1% of Keppel DC REIT’s income. As a result, the impact on distributions has been limited. 

#3 - Marginally higher cost of debt

As interest rates continue to go up, Keppel DC REIT’s borrowing costs are also closely watched. 

Here, we saw the average cost of debt inch up from 1.8% in 1Q22 to 1.9% in 2Q22.  

The good news here is that about 76% of Keppel DC REIT’s borrowings are hedged to fixed rates.

As a result, the increase in interest rates is not expected to have a significant impact on its borrowing costs this year. 

Keppel DC REIT estimates that a 1.00 percentage point increase in interest rates will cause a 1.6% decline in its DPU.  

#3 - Healthy gearing for now

Keppel DC REIT’s current gearing (total debt/total assets) is healthy at about 35.3%. 

However, it is worth remembering that Keppel DC REIT had announced in June that it was acquiring two data centres in Guangdong, China, for about RMB 1.6 billion (S$338 million).

According to Keppel DC REIT, the acquisition is expected to be accretive to its 2021 DPU by about 2.6%. 

Upon the completion of the acquisition, Keppel DC REIT’s gearing would rise to about 37% of the transaction is funded 50% by equity. 

If it is funded entirely by debt, then Keppel DC REIT’s gearing would go up to about 40%. 

What would Beansprout do?

It’s understandable why so many investors are looking at Keppel DC REIT. 

The data centre REIT has fallen by close to 18% so far this year. Yet, the long-term growth story of data centres remains intact. 

So the question that everyone might have is - would we be buying Keppel DC REIT now?

The short answer is - We'd still be avoiding Keppel DC REIT for now. While the 2Q22 results might provide some relief to investors, the challenges that Keppel DC REIT faces have not gone away.   

Here are some of the near-term challenges it faces.

#1 – Electricity prices remain a risk

Firstly, Keppel DC REIT’s costs and hence distributions are still dependent on how electricity prices trend in the coming quarters. 

While electricity prices have come off in recent weeks, it’s hard to tell if we have already seen a peak. 

There’s always a risk that oil prices and hence electricity prices will spike again if Russia were to cut off gas supplies to Europe. 

#2 - Higher gearing when acquisitions are completed

While Keppel DC REIT’s debt level is not of a concern currently, its gearing will rise following the completion of the China data centre acquisition.

This would mean two things – it would become more difficult for Keppel DC REIT to make further acquisitions by just using debt in the future. 

Or it would have to do some form of equity raising to be able to fund further acquisitions. 

#3 - Need to make more accretive acquisitions. 

This brings us to one of the most important drivers for Keppel DC REIT. 

The reason why Keppel DC REIT has been able to do well in the past was that it was able to grow its distributions rapidly by making accretive acquisitions. 

Those were the days when it was trading at a yield of less than 4% and borrowing was cheap. 

Today, it is harder to make accretive acquisitions as the yield that Keppel DC REIT trades at and borrowing costs have gone up. 

On the other hand, with strong competition for datacentre assets, the valuation for datacentre assets has not come down. 

#4 - Dividend yield not significantly higher than safer assets

Keppel DC REIT currently offers a dividend yield of 5.0%.

This is only slightly higher compared to the 12-month T-bill that is offering a yield of 3.1%, and the 10-year SSB that is offering a yield of 3.0%.

Hence, we would be avoiding Keppel DC REIT for now, as the slightly higher yield offered is not sufficient to offset the risks from the near-term challenges that we see.